Final answer:
To illustrate Ricardian equivalence using the demand and supply of financial capital graph, you plot the initial equilibrium with foreign capital investment. Ricardian equivalence suggests that government deficit won't alter demand, as increased private savings offset government borrowing, keeping equilibrium the same.
Step-by-step explanation:
To illustrate the concept of Ricardian equivalence using the demand and supply of financial capital graph, we first need to understand the general scenario. The Ricardian equivalence theorem suggests that government budget deficits do not affect the level of demand in an economy because individuals will anticipate future taxes to pay off the debt and will increase their savings to pay for these future taxes, leaving overall demand unchanged.
Step 1. Draw a diagram showing the original scenario with a demand curve, D, for financial capital representing how much investment is desired at any given interest rate, and a supply curve, S, for financial capital including funds from foreign investors. The intersection of these two curves defines the original equilibrium, Eo, at interest rate Ro and quantity of financial investment Qo.
If the government increases borrowing by running a deficit, which in a basic demand and supply graph would typically shift the supply curve to the left (as government borrowing competes with other forms of investment for funds) and lead to a higher interest rate, under Ricardian equivalence, this would not occur. Instead, individuals save more in anticipation of future taxes, effectively shifting the supply curve back to the right, neutralizing the government's borrowing and keeping the equilibrium the same as before (Eo at interest rate Ro and quantity Qo), illustrating no change in the overall demand for financial capital.